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In the Trenches with Pension Reform

In the Trenches with Pension Reform

thomas j. healey, a senior fellow at Harvard's Kennedy School of Government, coordinates the work of the bipartisan New Jersey Pension and Health Benefit Study Commission.

Illustrations by Eric Hanson

Published January 17, 2017


For lack of a crisis (defined by Merriam-Webster as "an unstable or crucial time or state of affairs in which a decisive change is impending"), the nation's problems with underfunded state and local public pension systems continue to get kicked down the road. It seems that the public doesn't believe that the aforementioned "decisive change" really is impending. And with some reason: even Illinois, the state with the largest pension deficit, is not expected to absolutely, positively exhaust its ability to cover its pension obligations in the next decade. But, needless to say, fiddling while Springfield smolders will require some serious firefighting later on.

Absent deadline pressure, elected officials in states with major pension problems have been only too willing to hand off the hot potato to the next group of politicians – or maybe, the one after that. New Jersey affords a classic example. For decades, Republican and Democratic administrations alike failed to make required contributions to the public-employee pension system, landing New Jersey in dubious company. According to a report by JP Morgan Chase in June 2014, New Jersey joined Illinois, Connecticut, Hawaii and Kentucky in having debt and retirement benefit costs that, when properly funded, exceeded 25 percent of their states' revenues.

Actually, playing political football (or kick-the-can or hot-potato) with public-employee retirement programs is already leading to big trouble, albeit in unexpected places. Just look at Flint, Mich., where the city's battered finances infamously drove officials to cut corners by compromising the safety of its drinking water. As Barron's put it earlier this year, "it's not a water crisis; it's a benefit crisis. Flint's money shortage came about largely from high municipal pension obligations and a retiree health plan that could not be properly funded after the biggest taxpayer, General Motors, moved out."

Or consider Detroit, where the nation's largest municipal bankruptcy (July 2013) was precipitated in large part by rampant debt from pension obligations. Even after substantial benefit cuts, current and future retirees are entitled to pensions worth more than twice the city's current income tax receipts.

That said, in most places the public employee benefits crisis will be recognizable while it's still possible to resolve it without wrenching sacrifices. Even in New Jersey, a dawning recognition of the severity of the problem gave birth to an aggressive reform initiative, though the growing pains around that effort show how even the most well-intentioned efforts can be stymied by partisan politics and voter apathy.

Playing political football (or kick-the-can or hot-potato) with public- employee retirement programs is already leading to big trouble, albeit in unexpected places. Just look at Flint, Michigan.
Challenge: Changing the Status Quo

How imminent does a funding crisis have to be for the public to accept the need for decisive change? The nation's Social Security system serves as a sobering example. It wasn't until that mainstay program drew within 40 days of running out of cash in 1983 that the public's attention became focused on the problem and elected representatives felt sufficient heat to pass legislation that reduced some voters' future benefits.

Public pensions are subject to the same unforgiving laws of apathy. To the vast majority of taxpayers, actuarial terms like depletion dates and unfunded liabilities evoke a desperate urge to change channels – not a sense that change must come soon.

New Jersey is again a textbook case. In a period of 18 months, New Jersey's Pension and Health Benefit Study Commission, a bipartisan blue-ribbon panel appointed by the governor, issued a series of reports setting forth the hard facts. First and foremost, two decades of missed payments and unfunded benefit expansions had dug the pension plans into a $44 billion actuarial hole by July 2015, up from $40 billion just 12 months earlier. But wait; the reality is even worse: the shortfall under new reporting conventions from the Government Accounting Standards Board now stands at $95 billion.

Closing a $44 billion gap (never mind the $95 billion) would have required each of the state's 3.2 million households to sit down and write a check for nearly $14,000. The reports also stressed that the bill for public employees' health benefits would jump from $3.1 billion in 2015 to $3.7 billion in 2016 and was already the third costliest in the nation per employee. Gilding this poisonous lily, the commission further pointed out that with benefit costs growing faster than state revenues, any attempt to fully fund promised benefits would lead to massive tax increases or draconian cuts in public services – if not both.

There are still people around who believe the stock market will manage what taxpayers won't. Indeed, the long-term return on equities (1950-2009) was a fabulous 7 percent after accounting for inflation. Pick your endpoints with careful attention to hindsight and the light at the end of this tunnel becomes truly dazzling: from 1982 to 1999, the average annual return on the S&P 500 was 18 percent!

But as the fine print on the mutual fund prospectus says, past performance is no guarantee of future performance. A more sober Moody's Investor Services projects that unfunded pension liabilities will grow by at least 10 percent in fiscal 2016 "under even our most optimistic return (5 percent return) scenario."

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Engaging the Unions

Hence, without a crisis to focus the public mind, the onus is on reformers to develop a game plan for engaging major stakeholder groups that is at once firm and fair (OK, if you insist: balanced). That means toughing it out with public-employee labor unions that have a great deal to lose from any credible reform. This was the case in Rhode Island, which faced what was considered the country's worst pension mess four years ago. The state's treasurer, Gina Raimondo (now the governor), developed a sensible, sweeping reform program that emphasized "the math, not the politics," as she diplomatically put it. Raimondo, a Democrat, pressed her case through a "Truth in Numbers" report that meticulously spelled out for taxpayers the enormity of the state's challenge and the cost of failing to act.

But this appeal to the better side of human nature didn't prove sufficient on its own. The public-sector unions took Raimondo to court (twice). But she was undaunted, and even without the backing of organized labor managed to prevail by communicating to citizens and legislators that her reform proposal – though not without demanding sacrifice – was evenhanded. Tellingly, that communication effort capitalized on the fact some Rhode Island municipalities had been driven to insolvency by their inability to control or fund their own benefits programs.

In New Jersey, the Governor's Study Commission rolled out its own truth-in-numbers accounting in three extensive reports, beginning in the fall of 2014. Among an avalanche of numbers, a few stood out: under a business-as-usual scenario, state-funded pension and health benefits would nearly double by fiscal 2023, gobbling up more than 27 percent of the state's budget and crowding out essential government services from education to social services to public safety. That 27 percent figure was almost in the rarified league in which Flint was playing: pensions and health benefits reached one-third of that crippled city's general fund in 2015 and were expected to hit an even more crippling 37 percent by 2020. The New Jersey commission concluded that the state could safely afford to spend up to 15 percent of its total budget on public-employee benefits, but to go beyond that level would dangerously stretch New Jersey's financial fabric.

The commission made that 15 percent threshold a baseline for its efforts to sketch out needed reforms. While the figure surely varies a bit from state to state based on how they allocate revenue and funding obligations between state and local governments, that general approach – determining the threshold of benefits spending that a state can sustain and adjusting pension and health benefits accordingly – could serve as a starting point for other states and localities.

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Minimizing the Impact of Change

Notwithstanding the math, the commission knew its proposal would have to be perceived as fair by the public. To that end, it developed a comprehensive program with the goal of maximizing savings to taxpayers while eschewing draconian benefit cuts. The reform package was built around five key goals:

  • Freezing existing pension plans while protecting all benefits earned by employees to date.
  •  Creating a fair and affordable new retirement program going forward.
  • Realigning public-employee health benefits with those offered in the private sector.
  • Applying a unified state and local approach to benefits funding.
  • Blocking backsliding on reforms by amending the state's constitution.

Freezing the pension plans means closing them to new members and eliminating further accrual of benefits to existing members. At the same time, the commission's approach assured all plan members that they would not lose any credit for service before the freeze and that retirees' pension checks would be unaffected.

This would set the stage for creating a new retirement program for active employees – a cash-balance plan, which the commission thinks is the most suitable prototype for New Jersey. Cash-balance plans are hybrids of classic defined-benefit and defined-contribution retirement programs [think of 401(k)s], with each employee's benefits as an account balance that grows each year through employer and employee pay-credit contributions. These accounts are regularly supplemented by credits at rates that effectively require employers and employees to share the risk on investment returns (in contrast to the state bearing all investment risk, as exists with current defined-benefit plans).

On the health benefits side, the commission was confronted with a system created long ago in smoke-filled rooms: rich coverage, combined with eligibility rules that encouraged gamesmanship and double-dipping. The commission focused on restoring fiscal order by realigning the benefits of active employees with gold-level coverage under the federal Affordable Care Act.

The system would work like this: retirees would use retiree reimbursement account funding from the state to secure health coverage through private exchanges that offer a wide range of competing plans. Early retirees would receive funding sufficient to purchase coverage comparable to that provided to ongoing employees with the option to purchase broader coverage at their own expense. Medicare-eligible employees would receive funding sufficient to purchase what is known as a Medicare Advantage/Prescription Drug plan – care from an organization providing broad, one-stop health services.

While the out-of-pocket costs of these plans are somewhat higher than the token outlays under the current state plans, the switch would save so much money over the status quo that the state could supplement the accounts with sufficient cash to offset the increase in average out-of-pocket expenses, while still yielding substantial savings. Overall, these reforms would reduce the state government's health benefit costs by about 30 percent.

Unfortunately, the fiscal hole from pension underfunding in the past was so deep that the increase in funding needed to cover even benefits earned prior to the freeze, along with the less-costly cash-balance plans going forward, would exceed the substantial savings from health benefit reforms. To close this gap, the commission pondered a variety of approaches – including a "millionaire's tax" on the wealthiest citizens, selectively cutting services, or putting New Jersey Turnpike and state lottery employees into the pension pool.

Computer simulations suggested, however, that none of these fixes would be adequate to the task. Instead, the commission advanced a unique funding mechanism: using some of the anticipated $3 billion in savings from health insurance reform at the local government level to reduce the state's funding burden. The idea here is to ask localities to reassume responsibility for benefits that, over the years, had migrated to the state's side of the ledger. Since only some of the savings would be used up in the process, this change would be cost-neutral to municipalities – meaning taxpayers could actually see a reduction in their property taxes, which are the highest in the nation.

It's likely other states with pension woes could put this multipronged approach to effective use. More specifically, by moving costly public-sector health benefit plans in the direction of more cost-effective (though still high-quality) coverage in the private sector, governments could help put wobbly pension plans on a sound fiscal track.

The question is how to reform a political culture dedicated to dealing with today's problems tomorrow and tomorrow's problems never.
Is Anyone Accountable?

Regardless of how fair the plan, reformers must contend with this inconvenient truth: elected officials like to promise benefits to public employees but don't like asking voters to pay for them. How else to explain that, according to Robert Inman, the Wharton finance professor, there are currently $3 trillion of unfunded pension liabilities at the state level and $400 billion at the large-city level? That comes out to roughly $10,000 per American citizen. Chicago – often held up as the poster child for pension irresponsibility – has chalked up unfunded liabilities that amount to 10 times its annual revenues, while Illinois is the most poorly funded pension state in America.

New Jersey fits comfortably into this narrative of elected officials behaving badly. For years, the state granted pension benefits it could afford only under wildly optimistic assumptions about investment returns. When reality fell short of those assumptions, administrations from both political parties failed to either fund the accruing liabilities or to reform the underlying benefits system.

In one memorable example from the early 2000s, the Legislature saw fit to enhance retirement benefits going forward while finding a way to sidestep obligations that already existed. The state's efforts to conceal this fiscal sleight of hand in the small print of bond disclosures eventually drew the ire of the U.S. Securities and Exchange Commission. The result of two decades of this kind of gamesmanship is that New Jersey has one of the worst pension-funding gaps in the country and has suffered repeated downgrades in the state's credit rating as the cost of benefits outstripped its ability to fund them.

New Jersey is hardly alone in having its elected officials victimize both public employees and taxpayers in this manner. The question is how to reform a political culture dedicated to dealing with today's problems tomorrow and tomorrow's problems never.

One obvious focal point for reform is accountability. While federal law demands accountability from the private sector (where the Department of Labor has a strong enforcement tool in the Employee Retirement Income Security Act), public-sector accountability is almost nonexistent. New York is the only state I'm aware of in which a third party (the elected state comptroller) has independent power to appropriate money to fund pension obligations. Yet, though this model ensures high funding levels, it also has contributed to New York's extremely high benefit costs and taxes, and creates a dynamic in which the legislature has no responsibility for comptroller-mandated appropriations and the taxes required to pay them, while the comptroller has no responsibility for the legislated benefits requiring the appropriations.

It's fair to ask whether public employees even want a world in which pension accountability is well defined, as opposed to one in which elected officials have an obligation to fund mandated benefits in perpetuity regardless of cost. It's revealing that in New Jersey, public employees' reaction to evidence showing an irrefutable need for reform was to press the Legislature to put a constitutional amendment on the ballot that would mandate full funding of pension benefits and guarantee the right of most current employees to continue to earn future benefits under no-worse-than-current terms without creating a source of funding, effectively precluding fiscally meaningful pension reform for a generation.

After long deliberation, the commission concluded that the sweet spot – doing justice to both taxpayers and public employees victimized by elected officials promising huge deferred compensation – was a general rule in which taxpayers make good on any pension benefits actually earned to date while leaving the terms under which benefits would be earned in the future subject to change. Taking away a benefit that has actually been contractually earned would be unfair, even if this means that taxpayers must bear the burden of irresponsible government decisions made in the past.

Benefits promised but not yet earned, however, are another matter. For one thing, something has to give. For another, protecting future benefits from change would prevent voters from holding today's elected officials accountable for ensuring that funds in the existing budget are being spent in a way that best promotes the public welfare.

So-called non-forfeitable rights provisions, which seek to dictate the terms under which certain classes of employees will earn benefits in the future, are the ultimate manifestation of the kick-the-can-down-the-road mindset. These provisions permit one set of legislators to escape responsibility for granting a benefit without paying for it and a subsequent set to duck their fiscal responsibilities with the excuse that their hands were shackled by their predecessors.

Lessons Learned

Because pensions are about numbers while pension reform is about politics – two different universes with different time horizons – a state's constitution can be a useful tool for reconciling disparities. It can also ensure that the terms of any compromise can't easily be undone by the state's next chief executive and elected officials. As previously stated, though, any constitutional provision needs to be limited to protecting for benefits earned to date. It must also provide assurance that the government's overarching duty – the general welfare of state residents – comes first. What must be avoided are constitutional provisions, such as those in Illinois and Michigan, that give public employee benefits first claim on the public fisc and limit the state's sovereign power to adjust its obligations to overarching state needs.

Beyond constitutional support, having a strong public official who is widely respected at the helm of pension reform can be a huge tactical advantage. Raimondo's success against the odds in Rhode Island persuasively drives home the point. It also helps, of course, if a governor and legislators have a constructive working relationship – which in these partisan times too often means being from the same political party.

The fact that persistent officials in a handful of states are prevailing over inertia and hand-wringing is a hopeful sign. But in many more states with ailing systems, leaders need to accept the personal risks associated with doing the right thing for public employees, retirees and taxpayers.

Note, too, that Rome was not built in a day. Consider: while efforts to achieve larger systemic reforms have been stymied to date, New Jersey's latest budget does reflect some $150 million in health benefit savings championed by the commission. It also includes the first steps toward embracing the commission's central premise – that savings on health benefits are the optimal source of funding for closing the gap on pension obligations.

Clearly, this nation's pension imbroglio can no longer be relegated to the back burner. Well, perhaps not so clearly. But it certainly shouldn't be: unfunded liabilities are a disaster in the making that lurk behind a gray wall of numbers, graphs and pie charts. As Flint and Detroit found out, expecting the problem to recede with an uptick in the stock market or the imposition of a new tax or the wave of a consultant's wand is simply delusional.

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main topic: Economy: U.S.
related topics: Public Health, Demographics